Cost accounting is the general practice of taking costs or expenses that are recorded on a general ledger system and allocating the costs and expenses to volumes of provided goods and services. In a general ledger system, costs and expenses are recorded by the department or area in which they are incurred. Since products and services provided are typically supported by multiple departments or areas, the costs recorded on the general ledger for any particular department will therefore only represent a portion of the total costs for any particular product or service. This phenomenon is particularly true in healthcare, as a patient will likely receive services from many different departments during the patient's treatment.
In its first generation form, cost accounting in healthcare was introduced through its use as a government reimbursement methodology for Medicare. Given the government's commitment to reimburse healthcare providers based on their costs, a system was required to calculate the costs associated with the provision of services to Medicare patients.
The “Ratio of Cost to Charges” technique arose in response to the Medicare system. The technique allocated costs based on the portion of total charges for a particular department that were produced by Medicare patients. The higher that Medicare charges were as a percentage of total charges for a particular department, the higher the costs that would be allocated to Medicare patients, and hence reimbursed by the government. The ratio of cost to charge approach assumed that charges were a close approximation to the level of resources actually incurred in the provision of any chargeable service. At the time the approach was introduced, this was generally the case, as most providers established charge rates as a mark-up from costs of individual goods and services.
Over time, hospitals learned that by increasing the charge amounts for procedures that had a heavy utilization by Medicare patients, their reimbursement by the government could be increased. This process was known as cost-shifting, and became prevalent throughout the industry. The relative relationship between the costs and their associated charges for goods and services became distorted. Charges for services that were utilized heavily by Medicare patients were artificially inflated. In many facilities, the ratio of cost to charge approach resulted in inaccurate cost estimates such that charges no longer could be used as an estimate of resources utilized in providing any particular service.
Further cost accounting techniques arose as a response to payment methodologies later introduced by the government. The government changed reimbursement formulas from cost-based to a preset amount based on the diagnosis of the patient. Thus, cost accounting methodologies developed that focused on breaking down the provision of patient care into procedures. The procedure costs could subsequently be combined into the total costs for every patient based on the procedures used for each particular case or stay.
In response, many facilities initially developed a “bill of materials” for each chargeable procedure, which equated to a direct cost that could be identified based on the labor, supplies, and other materials used in that procedure. The method then calculated the difference between the summation of these individual costs and the costs reported on the general ledger, and allocated this difference using the direct costs as an allocation basis. This allocation procedure, generally called “Standards Development”, was derived from the management accounting practices used in the manufacturing industry.
For some institutions, the standards development approach was too costly to maintain due to the dynamic nature of how patients are treated in the healthcare setting. Based on individual physician preferences, changes in technology, and differences between costs of supplies and pharmaceuticals between various vendors, the list of resources used in the provision of services for any particular procedure could change monthly and even weekly. Most facilities that did not have a dedicated staff of management engineers ended up abandoning this methodology.
Subsequently, an approach called Relative Value Units (RVUs), evolved for allocation of general ledger costs to the individual procedures performed in a facility. Instead of building a bill of materials for each procedure, this approach uses a single statistic, or RVU, as the basis for allocation of general ledger costs to a chosen volume indicator. While this approach does not specifically identify the direct costs associated with each charge item, as long as the “relative” relationship between each charge item was correct for a particular department, the end result of the allocation of general ledger costs was very close to the total costs that were calculated using the earlier standards development approach. Limitations of the above approach became apparent in the industry. Specifically, healthcare managers noticed that these costs represented the average cost and not the actual cost of providing any particular service.
Further refinements have led to a methodology known as “Activity Based Costing”, which refines the unit indicators derived from charge items to actual activities identified in the provision of patient care. These activities, requiring manual capture, are then assigned a cost based on the amount of time required to perform the activity and the wage rate of the staff that performed the services. Effective use of this approach requires an investment to capture these activity volumes.
Accordingly, a cost accounting solution is needed that overcomes the difficulties of the above approaches. Specifically, a cost accounting method is needed that provides for automated association and accumulation of volumes. Furthermore, a solution is needed that eliminates distorted results and improves accuracy of cost accounting results.